This Share Traders’ Mistake Could Cost You a Fortune!

The letters ‘GFC’ have global recognition. And rightly so. It was one of the biggest financial meltdowns of all time.

Some sources say that 45% of global wealth was lost by March 2009. Trillions of dollars went up in smoke. Many people lost everything.

The social cost was overwhelming. Global job losses were close to 27 million. Around 250,000 of these were Australian jobs. It was a time of hardship and insecurity for many.

You can be sure of this: the GFC is a crash people will talk about for years to come.

But not today. I’m going to tell you a story from another crash. It was only seven years earlier. Yet it already draws a blank for younger traders.

What I’m talking about is the Dotcom era. This is one of the great boom/busts of our time. And it drew in retail traders like never before.

I remember watching a current affairs program of the day. It was profiling a new age trader — an everyday mum. Her classic line was ‘I can make $10,000 while making the kids’ lunch‘.

Then there was the host of a popular morning breakfast show. When the crash finally came, he had to take the day off to ‘attend to his portfolio’. It was speculation gone wild.

Many were hailing it a new era. They said it was different to other booms. The thinking was: technology would forever boost growth. Old school stock analysis was supposedly obsolete.

But you know what. It wasn’t different — it never is.

You see, markets move in big recurring cycles (my colleague, Phil Anderson, has an excellent service about cycles). The problem is that most people only focus on the immediate past. They simply don’t see the overall patterns.

Let me tell you a story about one of these people. His name is Tony. He was a stockbroking client of a colleague.

Tony was typical of many part-time speculators. He would take large positions in a few companies. The strategy was then to hold on and hope they went up.

Now Tony had been my colleague’s client for a couple of years. He had a few decent wins. But some big losses were adding up. His account was slowly heading south.

It was now late 1998. And the internet craze was about to hit top gear.

Tony called my colleague. He said ‘buy me 20,000 shares in Sausage Software‘. Sausage was an emerging IT company. Its shares were worth about $1.

Sausage shot to $2 a share within a couple of months. Just three months more and it was closing in on $10. Tony’s stake was quickly nearing $200,000.

Have a look at the next chart. This is what an 8-fold gain looks like.

My colleague advised Tony to sell half. But he wouldn’t hear of it. The media was in a frenzy over Sausage. And so was Tony.

Sausage was your classic trend following stock. It ran, and ran, and ran.

The shares hit a peak of $41 in March 2000. They had gone up 40-fold in just 15 months. It was what we call a 40 bagger.

Tony had run a $20,000 stake into a profit of around $800,000. He had also resisted all his broker’s calls to sell. Tony did exceptionally well to get this far.

There was just one more test — his exit strategy.

Think about this for a moment. What would you do?

It’s not as simple as saying sell. No one knew $41 was the peak. And anyone likely to take profit had probably sold out long ago.

Let me tell you what Tony did. He held on.

Sausage shares were back at $26 within just two weeks. Tony’s $800,000 paper profit was now worth $500,000. He saw $300,000 evaporate before his eyes.

My colleague was still pressing Tony to sell. But there was a problem. Tony was now focusing on the $300,000 he had ‘lost’ — not the $500,000 he still had.

Many traders make this mistake. They place more value on what they’ve lost than what they still have. The urge to get back to even overrides the need to get out.

Tony held, and held, and held. The shares were below $20 in days. Within two months they were under $10. And by 2003 they were trading for less than $1.

Have a look at this chart — it’s a wipeout.

Source: BigCharts

It all comes down to this. A good entry strategy only gets you so far. You also need a plan to sell. This is what separates the plodders from the performers.

Let me show you what could have been. This is what happens when we apply Quant Trader‘s exit strategy to Tony’s trade.

Look at the difference a robust selling method makes. It captures all but the final manic stages of a colossal bubble.

An excellent real-time example is the Chinese market crash. Opinion is split on whether this is a short-term correction or a long-term bust. The fact is, no one knows. That’s why you need an exit strategy.

Quant Trader had exposure to the boom through the AMP Capital China Growth Fund [ASX:AGF]. The system rode the trend up. But it won’t ride the trend all the way back down.

Have a look at this chart.

Source: BigCharts

Do you see the red dotted line below the share price? That’s the trailing stop — it’s the point where we exit a trade. It ensures you don’t end up like Tony.

A trailing stop won’t exit at the top — that’s for the crystal ball gazers. But it does the next best thing. It gets the big middle part of the trend. That’s where you make the money.

Successful trading requires multiple strategies. You not only have to get onto the big moves…you eventually have to get out. The trailing stop is the best way I know to do this.

Until next week,

Jason McIntosh

Editor, Quant Trader

Editor’s note: The basis of good trading is to stay with stocks that are rising. But that’s not enough. You also need to kill off the trades that are eroding your capital. Fortune favours the trader who masters this simple concept.

Quant Trader does this by uses algorithms — a collection of mathematical formula. These allow for consistent and unemotional trading. You can read more about Quant Trader’s algorithmic strategies here.

The Daily Reckoning offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, The Daily Reckoning delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors. Founded in 1999, The Daily Reckoning is published in 7 countries with a worldwide readership of almost 1 million people.

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